12/03/2008 @ 6:00AM

The S&P's Winning Stocks

The Standard & Poor’s 500 is so iconic it is typically simply called “the market.” As in, “the market’s down this week” or “this market’s driving me crazy.” There has been a lot of both to go around as the index of the U.S.’ 500 largest firms is down 43% year-to-date, enough to make even the most self-possessed indexer wince. Clearly, the canon of American capitalism is getting caned.

Unfortunately, the damage is even worse than it appears, once you take a magnifying glass to the index’s components. Of the 500 flagship firms of American capitalism, just 11 have seen their stocks rise in 2008. Let’s repeat that in another, slightly different, form: just 2% of America’s largest firms are in the black this year stock-wise.

Another astonishment is that of the firms that did make it, there’s just one Dow Jones industrial average component:
Wal-Mart
. And it’s not even near the top, up 11.5% this year. Actually, the top name, up 35% as of Dec. 1, is another retailer, but one that draws an even more bargain-conscious buyer than Bentonville’s best:
Family Dollar Stores
.

Why Family Dollar? In an era when a dollar actually means something again, the firm has put away some dollars of its own. And in an era where the heads of America’s top automakers have all agreed to take $1 salaries, maybe the single greenback is, well, back.

Patrick McKeever, analyst at MKM Partners, says the firm is one of the best-established defensive names in retail and should generate over $300 million in free cash flows in fiscal year 2009. In a year where firms are lined up for handouts, that kind of money in the bank positions Family Dollar for success. It also benefits from middle-income people trading down. In other words, they target
Target
.

Next up on the survivor’s list is plastic and rubber firm Rohm & Haas, up 33% in 2008. It benefited from increased sales in its paint and coating materials sector, despite weak domestic demand, according to
Credit Suisse
. Its packaging and building materials sector also saw sales swell despite weak U.S. demand, thanks to increased prices. So, if you can charge more you’ll still win, no matter how rough the market.

Robert Froehlich, chief investment strategist for DWS Securities, the retail arm of
Deutsche Bank
, sees four themes from the 11 firms. People will still shop, people will still eat, people will still pay for health care and cheap oil is profitable for chemical firms. But they aren’t paying top dollar for this stuff if they can avoid it.

John Osbon, founder of Osbon Capital Management, a believer in efficient markets, mostly stands amazed that these firms were the winners. As such, while he owns these names, he doesn’t own quite enough, he says.

Nick Raich, director of equity research for
National City
, sees these firms as classic defensive plays. If conditions worsen, these will continue to thrive, creating a slim, but real, silver lining.

Osbon: This list must drive stock pickers crazy. Who knew, and which portfolio manager has the highest percentage of these 11 names in his/her portfolio? I respect the stock pickers, but we invest as indexers, and indexers who index by style, capitalization, geographic and sector. I am sure we have all 11 names in our portfolios, just not enough of the 11 names and too many of the other 489!

Put another way, we want to be the market, not beat the market, and indexers have the U.S. 80-year 10% per year return weight of history on their side. Furthermore, “index” is not average. It consistently ranks in the top 20%, which is how we address the relative return question. But the last decade in the U.S. has been awful and tries the patience of even the indexers like us. Fortunately, the last decade outside the U.S. has provided good diversification and return opportunities.

Froehlich: I actually see four different investment themes emerging from this data.

No. 1: People in this country were born to shop. And shop they will, in both good times and in bad times. However, in bad times like we are facing today they will look for ways to get more bang for their buck. That’s the Family Dollar Store and Wal-Mart theme. I believe that deep-discount retailers will continue to do well for the next six to nine months and just may be the biggest story and biggest winners in this upcoming holiday shopping season.

No. 2: People are going to eat in both good times and bad. I believe that is the General Mills story. People will cut back on a lot of things before they cut back on food on the table.

No. 3: If you don’t have your health, you don’t have anything. I believe that drug spending is recession proof. That’s the story of Amgen, Barr Pharmaceuticals and Celgene. I expect the biotechnology and drug groups to continue to do well.

No. 4: Lower oil equals chemical profits. That’s the story of Rohm & Hass–a chemical company. Petroleum-based products are the No. 1 input cost for this industry. Oil has just fallen from almost $150 to below $50 a barrel. That’s like printing money for the chemical industry.

I believe these companies and, more importantly, these industries well be well-positioned for 2009. My investment strategy overweight discount retailers, food stocks, drugs stocks and chemical companies. Though it’s not as memorable as the B.R.I.C. (Brazil, Russia, India and China) concept, my R.F.D.C. (Retailer’s (Discount), Food, Drugs and Chemicals) idea will actually make you money.

Raich: The list clearly shows that companies in classic defensive sectors are in favor as most of the names on it were in consumer staples, health care or the utility sector.

Can they keep up their performance? I believe that depends on what happens to the macro-economy over the next 12 to 18 months. If conditions worsen, then most of these names, at the very least, will outperform the market. But if Bob’s forecast is correct, then I would imagine some of these stocks could still move higher but would most likely lag the S&P 500.

On the list, our research team is currently recommending the purchase of Amgen and Wal-Mart.